Contrary to the old saying, you can teach old dogs new tricks. But sometimes you need to ask why exactly the dog was willing to change his ways.
That’s my thought about Wall Street legend Burton Malkiel. Just recently, the New York Times spoke with Malkiel. What he said surprised me, to say the least, and left me questioning why he’s had a change of heart after so many years. Malkiel, one of the earliest Prophets of Passive, told the Times that he’s been sold on a current, more active approach to investing. Really?
This turnabout is most perplexing when we consider the body of Malkiel’s work. His seminal 1973 book “A Random Walk Down Wall Street,” did much to promote passive investing by arguing that a well-crafted index fund could easily out-perform a portfolio of stocks constantly being bought and sold by experts. The book’s headline-grabbing thesis was that “a blindfolded monkey throwing darts at the stock listings” could build a better portfolio than most Wall Street investment hotshots.
And Malkiel didn’t stop there. Over his tenured career in economics and finance, Malkiel has published several other books and numerous articles. For years, he was director of the Vanguard Group and trustee of Vanguard Mutual funds, the company that launched the investment industry’s first passive index fund.
Since then, passive investing has been the investment community’s default recommendation to folks looking to build a nest egg. The advice boils down to buy index funds that track the various markets, hold them for years, and reap the returns from the market’s long-term growth.
Today, Vanguard remains committed to a philosophy of passive investing. But for Malkiel, who stepped away from Vanguard in 2005, his philosophy has changed.
Malkiel has done an amazing about-face when it comes to his devotion to passive investing. Whereas before Malkiel believed that buying and holding index funds was the most effective portfolio management strategy, these days he’s flipped his own script. This economist and finance guru recently became the chief investment advisor for a new automated investment firm that uses sophisticated algorithms and software to identify stocks that could benefit from various anomalies and inefficiencies built into the market.
The strategy is called “smart beta.” So what is “smart beta?” In its basic definition, smart beta is an investment strategy that is rooted in index investing, but moves the needle from the passive end towards a more active approach. The “beta” part of the term refers to an index or index fund’s return. The “smart” part means that the funds weight stocks in an index based on a few select criteria, like low volatility, high quality or high momentum (rather than on market value, as in a typical index fund). Using a complex algorithm, smart beta touts the ability to outperform traditional index investing.
Confronted with this seeming renunciation of passive investing, Malkiel has claimed that his real objection to smart beta investing was that too much return from such portfolios got eaten up by high fees and taxes. As recently as 2016, Malkiel shared his concerns about the high fees associated with smart beta with the Wall Street Journal, where he concluded that this investment strategy doesn’t work for most individual investors. His belief in this point was so strong that he devoted an entire chapter in the newest edition of “A Random Walk Down Wall Street,” positing that not only are smart beta funds riskier, but they’ve all had long periods of underperforming the stock market.
Fast-forward a year later, and Malkiel’s tune has changed. Oh, and he’s taken a new position heading-up a robo-advisory firm that uses enhanced indexing, or smart beta. This plants an age-old question in my mind about the impetus behind Malkiel’s change of heart. Which came first – the chicken or the egg?
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If you ask Malkiel, advances in market research and technology now make it possible for companies like his employer to minimize fees and taxes on smart beta portfolios. Lower fees, Malkiel says, were especially crucial in making the smart beta strategy palatable to him.
Interestingly, Malkiel’s new paymaster insists its strategy isn’t at odds with their new Grey Eminence’s long-held philosophy. They adamantly deny being stock-pickers (like those monkeys?) and even call their product “PassivePlus.”
And to be clear, simply naming a strategy “PassivePlus” doesn’t mean it’s truly passive in practice. Quite the opposite is true. Despite Malkiel’s robo-advisory firm employer’s assertions that they’re not stock pickers, and they believe the decades of research that prove that active investors typically underperform their more passive counterparts, they are engaging in active investing to some degree. In practice, they make adjustments (albeit small adjustments) to basic indexing “to improve after-tax returns.”
So, what are we to make of Malkiel’s conversion – or defection? You be the judge. Looking at his professional timeline, Malkiel has been in the business for decades. He graduated with his doctorate degree in academic economics back in 1964. That translates into more than five decades of waving the passive investing flag. Why has he now chosen to put it down in favor of more active investment strategies after all these years? Only he knows, but I have my guess.